Knight avoids collapse with $400 million lifeline

NEW YORK — Knight Capital Group, the trading firm responsible for last week's stock market mayhem, avoided collapse by lining up a $400 million lifeline from a group of other Wall Street companies Monday morning.

But the money comes at a steep price.

Knight says it will get the cash infusion from an investor group led by Jefferies Group, as well as Blackstone, Getco, Stephens, Stifel Nicolaus and TD Ameritrade. In exchange, the group will receive stock that can be converted to a 73 percent stake in Knight, which means Knight is essentially handing over control to the investor group. Knight will also add three directors to its board.

Knight's stock has mostly been in free-fall since a massive computer error in its systems last Wednesday sent huge numbers of erroneous orders flooding into the market, causing dozens of stocks to swing wildly in heavy volume. Knight said the foul-up would cost the firm $440 million as it paid for stock positions it mistakenly bought. Early Monday Knight's stock took another pounding, dropping 25 percent, or $1.01, to $3.02. It closed last Tuesday at $10.33.

Knight's CEO Thomas Joyce, speaking in an interview on CNBC, said that only Knight, and not its clients, were hurt by Wednesday's snafu.

Joyce said his firm was still doing a post-mortem on the technical blunder and still didn't have a full understanding of what went wrong. He characterized the error as a "large" but "simple" breakdown on trading technology.

Knight Capital, based in Jersey City, N.J., is a trading firm that takes orders from big brokers like TD Ameritrade and E-Trade. It then routes them to the exchanges where stocks are traded, like the New York Stock Exchange.

Even with the cash infusion, it's not yet clear that Knight will regain the trust of other key players in the stock market to carry on and survive as a firm. Last week some of Knight's trading partners said they would suspend routing trades through them until the situation settles.

One of the roles Knight plays in the stock market is that of a "designated market maker." Those firms are responsible for keeping trading of the stocks they oversee orderly. They are viewed as particularly important during the open and close of trading, as well as during times when there is a lot of volatility in the market.

Ten minutes before stock trading opened Monday morning, the New York Stock Exchange issued a press release saying it was temporarily reassigning Knight's responsibilities of trading 524 NYSE-listed stocks to Getco, a rival firm and also one of Knight's new owners.

In another troubling sign of financial market malfunction, trading on Madrid's stock exchange was suspended for five hours Monday because of a technical glitch. An exchange spokesman didn't provide any further details. Spain's stock market has been in turmoil for months as the country's banking system teeters on the brink of collapse following the implosion of a real estate bubble there. Spain's benchmark Ibex-35 index surged 4.4 percent Monday, its latest gigantic swing.

Knight's blunder has been a disaster for the firm's current investors. The value of the company's stock is now down 70 percent from Tuesday, the day before the blunder occurred. By issuing more shares, the value of what's held by current investors is diluted among more shareholders. It also means the company's earnings are spread among a greater number of shares.

When a public company sells such a big portion of itself, it's usually required to ask shareholders for their permission first. But the New York Stock Exchange granted Knight an exception, after Knight's board determined that waiting for a vote "would seriously jeopardize the financial viability of Knight," the company said in a news release.

The investor group will receive 267 million shares that they'll be able to convert to common stock for $1.50 a share. The firm currently has about 98 million outstanding shares, according to FactSet.

The Wall Street Journal reported that Knight asked the Securities and Exchange Commission, the federal regulator that oversees businesses, for an exemption so it wouldn't have to buy back so many of the mistaken trades, but the SEC declined.

Knight's CEO, Joyce, confirmed on CNBC that he did speak to SEC chairwoman Mary Schapiro over the weekend. "We had a frank discussion, and she did what she thought was right for the industry," Joyce said.

The SEC does allow trading firms to cancel some erroneous trades, but it has gotten stricter about what qualifies ever since the notorious "flash crash" of May 2010, when another technical problem sent the Dow Jones industrial average plunging nearly 600 points in five minutes.

Joyce said he respected Schapiro's decision but added: "This was an error, by any definition this was an error, so we would have liked to see some more flexibility."

The trading disaster Knight caused has revived a thorny debate in the financial system about the merits of high-speed trading, where lightning-fast mathematical algorithms trade stocks in milliseconds and, as recent mistakes indicates, strain the system that is supposed to handle them. More and more stock trading is handled by computers, and many market players have called for stricter controls to prevent disasters from happening.

Those problems, which have severely damaged confidence in financial markets, have been becoming more frequent. In May the highly anticipated market debut of Facebook was marred by a series of technical bugs. Technical problems at Nasdaq delayed the opening of trading by half an hour and kept many investors from knowing if their trades had gone through.

At that time, Joyce was one of the most outspoken critics of Nasdaq. Monday, he appeared humbled by his own firm's mistake, but was also adamant that the two situations were different.